Is a 4-ounce potato "small?" Anyone can weigh a potato, but judgments of "small" and "large" are in the eyes of the eater. It is similar with mortgage insurance.
Since measuring the cost of mortgage insurance is more difficult than weighing a potato, I'll show you how to do it. But the measurement is just step one. Step two is deciding what it means for you, which you have to do for yourself. But to help in that, I am also going to show you how to convert the mortgage insurance decision into an investment decision, with which more people are familiar.
Lets take a concrete example. Assume I can obtain a 30-year fixed rate mortgage at 7.5% and zero points to purchase a $100,000 house. Without mortgage insurance, I could borrow up to $80,000 (80% of property value), whereas with mortgage insurance I could borrow up to $95,000 (95% of property value). The insurance premium on the $95,000 loan is .79% of the balance per year for the first 10 years, after which it drops to .20%.
The best approach to measuring the cost of the insurance premium is to view the loan of $95,000 as consisting of 2 loans: one for $80,000 which has an interest cost of 7.5% consisting solely of the interest rate; and one for $15,000 the cost of which includes both the interest rate and the insurance premium. The interest cost on the $15,000 loan turns out to be 12.7% if you stay in your house for up to 10 years, declining slowly after that to 12% if you stay a full 30 years.
Since the insurance premium is only .79%, how can the cost of the $15,000 loan be 5.2% higher than the cost of the $80,000 loan? The reason is that while you are borrowing an additional $15,000, you pay the premium on the entire $95,000.
The cost calculation above assumes that you take a fixed-rate mortgage with a loan-to-value ratio of 95%, and pay mortgage insurance for 10 years. Change the assumptions and you change the cost. For example:
- On 85% and 90% loans, the cost is 13.4% and 12.5%, respectively. While the insurance premiums are smaller, the incremental loans are also smaller.
- On smaller loans within the same mortgage insurance premium bracket, the cost is higher. For example, the cost of insurance on a 91% fixed-rate loan, which has the same premium as a 95% loan, is 14.3%.
- Adjustable rate mortgages have higher insurance premiums, and therefore higher costs, than fixed-rate mortgages.
Mortgage insurance costs can be reduced if you manage to get the insurance removed early. For example, if the insurance on a 95% fixed-rate mortgage is removed in 5 years but you stay with the mortgage for 10, the cost falls to 10.8%. However, if you move in 5 years and pay off the mortgage, there is no saving.
Here is a handy rule-of-thumb for estimating the interest cost on the incremental loan made possible by mortgage insurance, assuming the loan runs 10 years. Divide the total loan by the incremental loan and multiply the result by the annual insurance premium, e.g.,95,000 divided by 15,000 equals 6.33 which multiplied by .79% equals 5%. Adding that to the interest rate gives an estimated cost of 12.5% on the incremental $15,000 loan.
Is an increase in interest cost of 5 percentage points on the incremental loan "small potatoes"? The best way to answer this question is to view the choice between the smaller loan without insurance and the larger loan with insurance as an investment decision. Taking the smaller loan means investing $15,000 in a larger down payment that provides a risk free return of 12.5%. Is this an attractive investment?
Not if you don't have the $15,000. Even if you have it, you would be locking it up for an indefinite period, although you might borrow against it using a home equity loan. Or you may not be impressed with a 12.5% return if you can earn more than that in your business, or are paying more on credit card loans. On the other hand, if you have a bond portfolio earning 7%, you might well want to liquidate it to invest in the larger down payment.
In short, a 12.5% cost on an incremental loan made possible by mortgage insurance is like a 4-ounce potato. It will be "small" to some and "large" to others.
